Japan's Easy Money Tsunami

The more things change, the more they stay the same

by David Howden

The Bank of Japan has just embarked on one of the most inflationary policies ever undertaken. Pledging to inject $1.4 trillion dollars into the economy over the next two years, the policy is aimed at generating price inflation of 2% and further depreciating the Yen. The idea is to fight “deflation” and increase exports.

The end result of this policy will be an assuredly larger balance sheet at the Bank of Japan (projected to nearly double to $2.9 trillion). Despite being lower than it was 25 years ago, the Japanese Stock Index has increased by 70% since November of last year. However happy people have been about higher stock prices, eventually the economic effects will be harmful; indeed the recent stock price crashes foreshadow still more troubles to come.

In my own contribution to Guido Hülsmann’s recent edited book The Theory of Money and Fiduciary Media, I take a critical look at these exact policies – expansions of the money supply aimed at stimulating output by way of manipulating the exchange rate. At the 100-year anniversary of the publication of Ludwig von Mises’ The Theory of Money and Credit, we can see that Mises had already grappled with the issues of currency depreciation in a manner superior to modern monetary economics. Furthermore, with the refinement of his business cycle theory in his book Human Action, we find that Mises also outlined the detrimental effects of such expansionary monetary policies.

The exchange rate determines the price a foreigner will have to pay for a domestically produced good. Increases in the money supply will generate inflationary price pressures that will in turn increase prices. This leads to a higher exchange rate, which means it takes more domestic currency to purchase a unit of foreign currency. This makes it cheaper for foreigners to buy our goods so exports increase. Conclusion: countries can stimulate exports and increase the number of jobs in export industries by inflating their money supply.

Unfortunately, this is not the end of the story.

Depreciating your currency does make your export goods cheaper for foreigners to buy. However, it also makes it more expensive for you to buy imported goods. This helps to close a trade deficit and reduces foreign investment in your economy. However, if the goods you sell to foreigners are composed of many inputs that you have to purchase from foreigners the effect will be to drive up your cost of production.

Therefore, Japanese exporters will pay more for the inputs that they will need to import to construct the same goods they intend to sell to foreigners. This effect is especially noticeable in countries with large export markets, but only a small ability to supply the inputs for goods destined for export. No other large economy fits this description better than Japan.

Mises’ key insight was in looking at the long-term effects of such a policy, and in the process he examined the logic behind the short-term results as well.

The ineffectiveness of the policy in the long run is apparent when one understands how prices – both domestic and foreign – interact to determine exchange rates. Exports will be promoted in the short run, though the effect will be cancelled in the long run once prices adjust.

If the policy is ineffective in the long run, Mises demonstrated that the short-run gains are illusory. The same monetary policy aimed at depreciating the currency to promote international trade will reap domestic chaos.

Higher monetary inflation will reduce interest rates. One result of this policy will be greater consumption expenditures – what Mises coined “overconsumption” – as consumers save less and spend more. The other result of reduced real rates is what Mises referred to as malinvestment. Production plans must supply not only the amount of goods consumers want in the present, but also orient these production plans to produce goods in the future. The interest rate is what coordinates all these plans over time and is what entrepreneurs use to determine when to produce goods, and how long a production process should be employed. The negative effects of distorting the interest will only be revealed much later.

Upsetting the natural rate of interest through an inflationary monetary policy unbalances both consumption and production plans. The economy eventually succumbs to an Austrian business cycle as it tries to regain footing, and move to a more sustainable pattern.

The more things change, the more they stay the same. Ludwig von Mises was able to correctly identify the pitfalls of expansionary monetary policies over 100 years ago. Policy makers have yet to learn these important lessons, and consequently continue to plague their countries with the results of these failed measures.